Market Participants Assess Distressed Debt Opportunities

With all sorts of distressed debt investing opportunities now available after the excesses of the last few years, buyers and sellers are treading cautiously and looking for some kind of validation for pricing.

The government’s plan to repurchase troubled real estate-related assets from financial institutions is likely to make for price discovery in the market and provide a minimum price, or floor, for the asset prices, said Matthew Landau at iGlobal Forum’s real estate private equity summit in New York. Landau noted that Lehman Brothers made a good call in not selling its real estate-based assets at very steep discounts, considering that the government could pay more for the assets.

In fact, the troubled asset relief program (TARP) could even contribute to an upward pressure on prices, Landau believes. As for the possible risk of buying too early in the cycle and missing out on good deals, he noted that it is always difficult to time the market perfectly and investors need to buy whenever they feel comfortable and leave room in case things don’t go right.

Jeff Gronning, a managing principal with Normandy Real Estate Partners, agrees that the government program makes for price discovery and could provide some direction to a cautious market in which everyone is waiting for a bottom. Even then, he says, “The problem is so much greater than what TARP is designed to handle,” which means that until there is some kind of catalyst, people will not buy.

For instance, Gronning doesn’t believe the government will buy defaulted loans on office buildings. He expects the TARP program to be more securities driven. However, to the extent that banks such as Wachovia and Citigroup sell loans off their balance sheet, it will bring in some private capital and make for price discovery.

Thomas Deane, head of structured transactions and special assets at Wachovia Securities, noted that considering the problem is based on billions of dollars in assets, there won’t be a bottoming out until the first or second quarter of 2010. “Too much stuff needs to go out the door,” according to Deane.

The majority of the special assets Wachovia is working with right now are residential land related, but Deane sees more and more commercial real estate-related assets coming. He is preparing for an “exponential growth” in distressed assets on the commercial real estate side.

Deane has seen a lot of buyers pull back since they don’t want to buy at the wrong price. “Nobody is going to call the bottom. Do sensitivity analysis and have confidence in your abilities,” is his advice.

From the buyer’s perspective, Lawrence Ellman, North America head of investments for Citi Property Investors, expects that prices will come down and become more attractive. “So far, we haven’t seen prices to our liking,” he said. “We need more deal flow and sense of urgency on the part of sellers.” However, lenders that are working with developers on assets in transition are beginning to see reality — such as a possible need for a haircut on the loan — and the borrowers are following along.

As for the due diligence involved in distressed debt investments, Gronning cautioned that it is much more of a complicated situation than underwriting a straight investment bought from a seller. In a distressed loan investment situation, the buyer has to work with whatever input the lender on the loan provides. The investor has to understand all the security documents and get information about matters such as who has recourse.

The documents can influence the outcome of the investments and make it favorable or not for the buyer. “It requires a different skill set and level of sophistication, depending on the nature of the transaction,” says Gronning.